Adding insult to injury? Taxation of awards for discrimination

A recent decision has highlighted the different approaches that are adopted by the EAT and HMRC in relation to taxation of awards for injury to…

A recent Employment Appeal Tribunal decision in the case of Timothy James Consulting Ltd v Wilton has served to highlight inconsistencies between, and the different approaches that are adopted by, the EAT and HMRC in relation to the taxation of awards for injury to feelings.

The issue

Rather unusually it is not the facts of the case that are important as much as the principles.

The central issue concerns the tax treatment of awards for injury to feelings. The tax treatment of these awards is important as it determines whether or not the employer, in making an award for injury to feelings, should “gross up” the amount of the payment to reflect any tax payable on the sum.

The tax treatment of awards for discrimination is complicated. However, broadly speaking, previous tax cases seem to distinguish between discrimination that occurs before an individual’s employment is terminated and discrimination that relates to the termination. The former is often held to be tax free while the latter, that may well form part of a payment compensating the dismissed employee for financial loss, will be subject to tax.

The decision

However, the EAT’s decision in the present case was that any awards for injury to feelings are not taxable and should not be “grossed up”, irrespective of whether the payment relates to discrimination arising out of the termination or before the termination.

The basis for this decision was:

the tax code (section 406(b) of the Income Tax (Earnings and Pensions) Act 2003) provides for an exemption from tax for payments or other benefits "on account of injury to, or disability of, an employee";

“injury” in this context includes injury to feelings; and

there is no requirement or qualification in section 406(b) that such “injury” must be "in connection with the termination of employment".

In this respect, the EATs decision therefore followed (and endorsed) that of an earlier EAT decision in Orthet Ltd v Vince-Cain.

Conflicting cases

The issue arises because in the intervening period HMRC, supported by decisions in the First-Tier Tribunal (Tax Chamber) (FTT), have appeared to establish that for tax purposes it is only where the discrimination occurs before termination that the payment will definitely fall within the section 406 exemption.

If, on the other hand, the award for injury to feelings is in respect of discrimination arising out of the termination of employment then the most recent decision of the FTT in Moorthy v HMRC and the position that has always been adopted by HMRC, is that the award is a termination payment and taxable under section 401 ITEPA 2003.

So where does that leave us?

Well, despite having acknowledged the conflicting state of authorities, the EAT is likely to follow the decision in Timothy James Consulting Ltd v Wilton and therefore will not gross up any awards for injury to feelings even though HMRC will look to tax the award unless it clearly relates to discrimination occurring before (rather than out of) the termination.

This is an unsatisfactory position. This decision simply represents the EAT’s views which are not binding on HMRC or the FTT. This conflict is therefore unlikely to be resolved, at least in the short term.

While this state of uncertainty exists, any claimant who receives an Employment Tribunal award or settlement sum faces a very real risk that they will be pursued for tax by HMRC, even though tax has not been taken into account when deciding how much they should receive.

It is therefore highly likely that claimants will ask you during any settlement negotiations to provide an ‘indemnity’ stating that you (as the employer) will meet any future demand for tax. Either that or they will ask for a larger settlement sum, to offset the tax they are otherwise likely to have to pay.

It is strongly advisable to take legal advice if you are asked to provide such an indemnity. You may need to take into account the possibility of a future demand for tax when deciding how much you want or can afford to pay an employee in settlement.

We would be happy to talk you through the tax implications of any payment you are considering making to an employee and assist you in protecting your position.

Haydn Rogan is a Corporate Partner and tax specialist with Weightmans. If you have any questions about this article please get in touch with Haydn (haydn.rogan@weightmans.com or 0161 214 0517) or speak to your usual Weightmans contact.